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FAREED ZAKARIA, HOST: This is GPS, THE GLOBAL PUBLIC SQUARE. Welcome to our viewers in the United States and around the world. I'm Fareed Zakaria.

I believe that we are all watching a major policy experiment unfold, perhaps the most important in decades. You see, the governments of the world's largest economies seem to be set to begin withdrawing the money that they had started spending last year to rescue their economies. This is happening in the United States, China, Europe, and it is turning into a test of two profoundly different views of economics.

The first that is apparently being adopted by the G-20 countries says we have to start paying down our debts because otherwise the cost of borrowing money will get prohibitively high. Today, it's Greece, tomorrow it's us.

On the other side are those who are saying this is crazy. Cutting government spending will put the economy in a tailspin. It will lower growth, lower confidence, and it will produce persistent and rising unemployment.

So should the government worry more about unemployment today or the bond markets tomorrow?

The two most important intellectuals in this debate are Paul Krugman, the Nobel Prize-winning economist, "New York Times" columnist, Princeton professor on the one hand, and Niall Ferguson, the Harvard historian, business school professor and author, on the other. Today we are going to be talking to both to give you the best case on each side. And I'm actually going to push off my own take on the subject until I've listened to both of them, and then you'll hear from me as well.

We've also got some startling news for you about al Qaeda and a very sweet story about July 4th.

But first, Krugman versus Ferguson. The stakes are only the future of your prosperity. You won't want to miss it.

(BEGIN VIDEOTAPE)

ZAKARIA: And now I welcome the Nobel Prize-winning economist, Princeton University professor and "New York Times" columnist, Paul Krugman. Paul, good to have you. PAUL KRUGMAN, NOBEL PRIZE-WINNER: Good to be on again.

ZAKARIA: You wrote in a column last week that you thought the world was in danger, in fact it was likely to enter a third depression. Explain what you meant.

KRUGMAN: A depression - we don't have a formal definition, but a depression is an extended period when the economy does badly, when there are periods of recovery but they're weak. Then they're followed by further slumps, unemployment stays high, there's a constant pressure toward deflation.

Worldwide, we've only had two of those. One, the depression everybody knows about, which was very extreme. But then, a more moderate but still ugly period of probably a decade or more after the panic of 1873.

This is - really, this is - we're - we've just experienced the - probably the - only the third really global financial crisis, again, 1873, 1929, and now this one. And we're responding to it in ways that almost guarantee, unless we do a u-turn on policy, guarantee that this is going to be another period like that.

ZAKARIA: You saw what the G-20 agreed to -

KRUGMAN: Yes.

ZAKARIA: -- the 20 richest countries in the world, as a major step backwards and a very dangerous step.

KRUGMAN: That's right.

Now, the - like all international meetings, it wasn't very binding. It wasn't clear exactly what follows. But what mattered was the mood. The mood was all -- you know, we're not - we've basically dropped any discussion about doing further things to bring down unemployment, and instead it's all about budget austerity and we've got to bring those deficits down without any context and at a time when this is really not - should not be our first priority.

ZAKARIA: Why do you worry so much about unemployment? Other than the human cost. You talk about how persistent unemployment, if people stay out of the job market for a long time, it sort of feeds on itself and they then never get employed.

KRUGMAN: That's right. There are a couple of things. One is that - that effect, history resists (ph), in the jargon. But basically, if - if they - if a worker's been out of the workforce for three, four years, it's going to be very hard for that person to get back in. The job references will be bad. The - the experience will - will be lost.

We've seen that happen in European countries that had high unemployment and by the time they finally started to get it down again some of that unemployment have basically become structural, had gotten built in. So that's one thing that's very severe. If we do this - if we don't deal with this now, we may find that 7, 8 percent unemployment is the new normal.

The other thing is that each - each year that we go on like this, we're drifting closer to deflation. You know, the -

ZAKARIA: Explain what that means and why is that dangerous?

KRUGMAN: So deflation is when prices are falling instead of rising.

ZAKARIA: And?

KRUGMAN: And we're - we're actually, you know, most of the way there. We came into this crisis with underlying inflation, around 2.5 percent, which is good. You want a little bit of inflation, gives you more flexibility. That's now down under 1 percent. It quite easily could be negative by the end of next year.

That's bad because when your problem is that people are not spending enough, that there isn't enough borrowing, there isn't enough investment, there isn't enough demand in the economy, deflation -- well, deflation makes holding onto cash, just sitting onto - on idle cash look like an attractive thing to do, and -

ZAKARIA: Because prices will drop six months from now -

KRUGMAN: That's right. That's right.

ZAKARIA: -- and you're always waiting for prices to keep dropping.

KRUGMAN: In Japan, which has now been in deflation for about 15 years, I was told some time ago by a Japanese economist that the only consumer durable that was selling well was safes, right? People were hanging on to lots of cash, and basically, we're already part of the way there. A lot of companies are sitting on cash because hey, it doesn't really erode in value given that we have almost no inflation, and if it becomes deflation it's going to be even worse.

ZAKARIA: So your solution to this, this is the part that I think a lot of people have trouble with, with the United States running a budget deficit of 10 percent of GDP, with debt to GDP ratios moving up into the 60, 70 percent range, you're saying what we need is more - significantly more government spending?

KRUGMAN: Right. And sure, I mean, I - we do have a long-run budget problem. So, you know, the starting point is to acknowledge that, that there is a problem, that if you ask about the state of the U.S. public finances 15 years from now, under current policy it looks pretty grim. So something will have to be done.

The question is what about now? And if we skimp on supporting the economy now, first of all, we deepen these problems. We make higher unemployment. We reduce the long-run prospects. Secondly, we do amazingly little to improve our long-run budget position.

I'll give you a number. Suppose we talk about a trillion dollars, more or less, of spending in the next year or two. A trillion dollars, the U.S. government can currently borrow, if it issues inflation indexed bonds, it can currently borrow at an interest rate of about 1.7 percent.

So a trillion dollars of spending is going to add to future interest costs only $17 billion a year, with a $2.5 trillion federal revenue base. It's not going to make a significant difference. But it could make all the difference in the world to the state of the economy in the near term.

So the arithmetic says that yes - well, the arithmetic is basically saying, (INAUDIBLE) arithmetic that says, oh Lord, make me chaste and continent but not yet. Yes, let's - let's have serious fiscal adjustment but not until the economy has recovered.

ZAKARIA: But a lot of people look at the stimulus, $800 billion, and they say we did everything Paul Krugman wanted, and it didn't work.

KRUGMAN: As it happens, I have - I have a track record here, because, at the beginning, when the stimulus was being discussed, I looked at what we knew even then about the severity of the financial crisis and said this is not enough. And so it has proved. I mean, this is - you say $800 billion, and it sounds like a huge number. You say that even on the administration's own forecasts at its peak it would only produce unemployment that was around 1.5 percentage points lower than what it would otherwise have been in a - in a world in which it was fairly predictable, we were going to see a large rise in unemployment.

This is what you expected to see, maybe a bit worse but this is - this is not - you know, if - if Obama and Congress had given a stimulus of the scale that people like myself said was necessary and that had failed, then we could have a discussion. But, in fact, they did something inadequate and the results are disappointing.

ZAKARIA: But when you look at - look around, you don't see federal dollars at work. Is that - is that a reasonable criticism? You know, people compare it to the '30s and they say where did all the stimulus money go? We don't see the WPA-type projects. We don't see massive new infrastructure.

We spent - you know, at the end of the day it's still a large number. I know you would have preferred $1.2, $1.3 trillion, but $800 billion is a lot of money, and where did it go? Why did it not have an effect?

KRUGMAN: Well, first of all, a third of it was tax cuts, which we didn't was going to be very - you know, in principle was not going to be very effective because they would be largely saved. A lot of the rest was aid to state and local governments, which helped avoid job cuts, helped make the job cuts at that level less than they would have been, but that's not visible. It's something that didn't happen.

Unemployment benefits, again, it's invisible, although it's made a huge difference to a lot of people, and the fact that they're running out is going to be a huge problem.

And they did not do enough. There was not a whole lot of stimulus of - of, you know, actual infrastructure. Some of that is coming on line now, finally, but I would have been for an all-out push to get a lot of public work spending upfront, and, in a way, that's saying, you know, we can still do that. If we had the political will, we could do that now.

ZAKARIA: When - when you look at Europe, you think that the Europeans -- you think the British government is doing exactly the wrong thing because they're going down this - this path of austerity, cutting spending, raising taxes. But what they say, I think, is, look we don't know when this - you know, this - this wheel will turn. We are in a situation where our borrowing costs could go up so dramatically that it makes it impossible for us to do anything.

KRUGMAN: I have been thinking about this in terms of there are two imaginary creatures who are dominating the discussion. There's the - the invisible bond vigilante and the invisible austerity fairy, or the confidence fairy, I guess I would call him.

The - the invisible bond vigilante is the hypothetical investor who any day now is going to turn on you and - and drive up your borrowing costs if you don't slash - if you don't cancel all notions of stimulus and - and so on, and everyone points to Greece, which - you know, but Greece is a very special situation.

Look at Germany or the United States or Britain, and the bond vigilantes are invisible. As of -

ZAKARIA: In other words, they can borrow quite cheaply.

KRUGMAN: That's right. U.S. interest rates have actually been dropping. The 10-year bond rate in the U.S. has fallen from 3.9 a few months ago to 2.9 now. And one of the things you notice is that in press reporting, every little uptick of interest rates is reported as ah, the markets have lost confidence and then, you know, it's like those Victorian photographs of fairies that - that weren't really there.

The fact of the matter is there's no sign of this happening, and it actually shouldn't be happening because for the reasons we talked about a few minutes ago, what you spend on stimulus right now has almost no bearing on your long-run fiscal prospects.

ZAKARIA: But - but just stay with that for a second because Greece didn't have trouble nine months ago.

KRUGMAN: Right.

ZAKARIA: In other words, are people not right in worrying about what economists call tail risk, that is the small probability of a high-impact event? Isn't that what the financial crisis taught us, that when things are out of whack you don't know when the things will turn, but they can turn pretty fast. KRUGMAN: But why should they turn on the basis of spending that has almost no bearing on your long run prospects? I would say even in the case of Greece what matters was not the spending they did in 2009, what mattered was the realization that the long-run budget position is basically unsustainable.

What we do, cutting out on - failing to pass unemployment benefits for the United States now is not going to rescue us if the markets believe that we are not going to do the big things on Medicare and revenue that are going to be necessary for the long run.

So it's - yes, it's fine to believe that something terrible could happen, but it's a pure imputation of - of motives for which there's no evidence to believe that - that spending on the economy right now is going to make the difference.

ZAKARIA: Well, I've spoken to a businessman and I was trying to put forward, you know, the Krugman view, and he said - which, you know, in some ways he thinks is also the administration view and he said look, the problem here is that what these guys are trying to, do the Keynesians, the people who want to spend more money, is they're trying to reflate the economy and - and pump it back up to where it was in 2005, 2006, 2007, but that was all unsustainable.

You're - you're sort of trying to stop these mortgages from being foreclosed but people had bought houses they couldn't pay for. You're trying to somehow get people borrowing again, but they were borrowing too much. Why are you trying to, you know, re -- sort of pump back up an unsustainable situation?

These - you know, these people, these companies should be coming back down to more manageable levels of debt, and that's going to take a while.

KRUGMAN: But why should lots of perfectly good, productive capacity and millions of perfectly productive workers who have things to do that we all need be left unemployed while we do that adjustment?

I - I certainly believe we're not going to restore - housing prices are not going back to where they were. We're not going to -

Some of those - some of those ghost developments, both of office buildings and of houses, are going to be abandoned. They're never going to be used.

But why should we have mass unemployment of schoolteachers, of automotive workers, of - you know, of all these parts of the economy that had nothing to do with the bubble but are now caught up in the tailspin as the economy suffers the aftermath of the bubble? Why should those people be left unemployed?

ZAKARIA: You realize that there is right now very little political prospect of your recommendations being enacted?

KRUGMAN: Right. I don't expect to win this debate on policy this month, but I'm hoping that over the course of a year or two that - that we can hope to at least - at least make policy less awful than it would otherwise be.

ZAKARIA: Make policy less awful than it would be. That's a - that's ringing cry to the battlements.

KRUGMAN: Well, hey, I'm an economist, right? They don't call it the dismal science for nothing.

But, no, I mean, this is - and - and also, I think there's a question you just have to - let's get this - let's get the story of what - what had just happened right. What we just had was a kind of hysteria among the policy elite in which - in which based on really no evidence, based on arguments that don't hang together as soon as you do even a bit of the arithmetic, we've had this rush for the exits on - on helping economies in need.

And we need to know that. We need to understand what - that what happened was not a judicious response or - and certainly not something that was forced on us by the - by the real economic environment but instead a bad decision.

ZAKARIA: Paul Krugman, pleasure to have you on.

KRUGMAN: Good to be on.

ZAKARIA: And we will be right back.

(END VIDEOTAPE)

(BEGIN VIDEO CLIP)

NIALL FERGUSON, HARVARD UNIVERSITY: Once you suddenly find your interest payments rising, it's very quickly a - a shift into a death spiral, a kind of tailspin in which things compound. The Greeks have been there, Spain is there now. Japan could be next, the U.K. teetering on the brink.

(END VIDEO CLIP)

(COMMERCIAL BREAK)

(BEGIN VIDEOTAPE)

ZAKARIA: And now I welcome Harvard University's historian and business school professor Niall Ferguson. Niall is the author of 10 books, most recently "High Financier: The Lives and Times of Siegmund Warburg". Niall, welcome.

FERGUSON: Hi, Fareed.

ZAKARIA: So you have an economy that seems to be slowing. Private sector job creation is very low. The consumer, who is 70 percent of the American economy, is spending a little bit more than he or she was a year ago but not enough to get us out of the woods. Interest rates are very low so, the Federal Reserve can't really pull interest rates lower.

What is really left than a second stimulus?

FERGUSON: The question which is absolutely crucial here, Fareed, is what is the next move going to be? Are we going to try and play that Keynesian card again and have another fiscal stimulus, or are we going to just come to terms with the reality that there probably have to be tax increases and spending cuts pretty soon if the United States is to retain some kind of fiscal credibility in the international bond market?

Now, that is a very unpleasant pair of options that Treasury Secretary Geithner is - is contemplating.

And if you get this wrong, for example, if you go for another stimulus but the financial markets say, whoa, that's a stimulus too far, we'd like to charge you a higher interest rate for your borrowing, then you end up in a worse place. If you go for fiscal tightening, which is kind of baked in the cake, tax increases are coming and coming soon, then you risk actually choking off such recovery as there is.

So in some ways if you think of a financial crisis as a chain reaction, as something that goes from one phase to another without ending happily and quickly, we're entering a new and really quite scary phase. Europe is already in this phase. The fiscal crisis, which is the next big phase of the crisis, is happening there now. The worry is that at some point in the next two years something similar is going to happen here and the U.S. is not going to have a Keynesian stimulus option anymore.

ZAKARIA: But somebody like Paul Krugman listens to -

FERGUSON: Is there somebody like Paul Krugman?

ZAKARIA: Yes. A columnist named Paul Krugman, who perhaps is unique, but Paul Krugman says when he listens to the kind of thing you're saying that people have gone mad, we're in the midst of a potentially deflationary situation, the economy is doing badly, it's fragile, it's weak, interest rates are low, you have got to spend government money now. It's the only hope for the economy.

If you do it, you can borrow cheaply, you can spend the money now, and then you will get more growth and that will mean much bigger tax revenues, worry about the - the deficit later.

He had a column I think a couple of days ago in which he said is this so difficult to understand? Spend now when you need to - to jumpstart the economy, save later.

FERGUSON: I would say the U.S. has a kind of stay of execution while the European crisis unfolds, but at some point the nasty fiscal arithmetic will get any country, even the United States, which is seen as, of course, the most attractive, the most safe haven country to invest in. I've been saying for a while that U.S. treasuries are a safe haven the way Pearl Harbor was a safe haven in early 1941. It's safe until it's not safe. It's safe until the bond market says wait a second, this isn't sustainable, we'd like a risk premium. Once you suddenly find your interest payments rising, it's very quickly a - a shift into a death spiral, a kind of tailspin in which things compound. The Greeks have been there. Spain is there now. Japan could be next. The U.K.'s teetering on the brink. And at some point I think in the next couple of years, the reality will be that the Paul Krugman recipe ends up having costs that exceed the benefits.

ZAKARIA: What else do you do? Do you wait and hope?

FERGUSON: What's frustrating to me is the - the way the discussion is conducted it seems like there is only a Keynesian option and the alternative is just sort of passively waiting for disaster. I think there is a better strategy that we could adopt.

Imagine radical fiscal reform that attacked not only the - the entitlements problem, that fundamental problem of Medicare, Social Security that is going to bankrupt the country if something isn't done, and rationalize the tax code. Simplified income tax, maybe even create just a simple flat tax rate. Simplified and reduced corporate tax, created a federal sales tax. There is a way of creating a confidence-boosting fiscal reform. It's pretty radical. It has almost no congressional support. But it is an option that we should be discussing much more seriously.

I'm depressed how few people in Washington are prepared to talk about this option. It seems to me actually our best hope.

ZAKARIA: What you're describing is - something close to the Republican Paul Ryan's plan. You told me off camera about a meeting you went to which demonstrates the enormous political support that plan has.

FERGUSON: Right. So I was -

ZAKARIA: Talk about that meeting.

FERGUSON: -- very excited to hear that there was going to be a dinner in Washington at which Republicans in particular committed to radical fiscal reform would gather around and one of them would be Paul Ryan. So I wondered just, you know, how big a - a hotel they would have to hire to contain all the Republicans who would surely be interested in this.

Actually, there were three congressmen there and we were quite comfortably able to fit into a room one quarter the size of this studio. And that I found at one level very depressing. It's also encouraging because in Ryan there is a serious thinker on the Republican right who's prepared to grapple with these issues of fiscal sustainability and come up with a plan, his so-called road roadmap.

And that's a plan the Congressional Budget Office has given an extremely impressive rating to. Now, that's the alternative we need to talk about as well as the Keynesian option, the Krugman option of more deficits, more stimulus, let's just hope that works.

One reason I'm skeptical about that, that response is that we used to do this. It's not like we haven't tried Keynesianism in the past. Indeed, it was orthodoxy for most of the '60s and '70s that what you did in the face of unemployment was you ran deficits and you printed money. And guess what we ended up with, the 1970s stagflation, double-digit inflation and low growth.

I don't quite understand why Keynes is what - is suddenly so fashionable and is suddenly our only option when we did use to try that and it didn't work brilliantly. We need to look at some radical alternatives.

I've been thinking a lot recently about the work that Tom Sargent at NYU, at New York University has done over the years. What you need is a regime change, not in the sense of Iraq, but in the sense of a policy regime change that boosts confidence. One thing that is depressing private sector hiring is the fear that small businesses have in this country, a) that they can't get a loan and, b) that they're going to be clobbered with higher taxes in the very near future.

If you could take away those fears and make ordinary businessmen feel that we were going back to the - the great years of the '80s and '90s, I think you would start to see that private sector job creation, which is clearly the key to recovery.

ZAKARIA: When you look at the politics behind the kind of plans you're talking about and, you know, there's parts of the Ryan plan, frankly, that I think many Democrats would like because there is a value added tax, a sales tax. Who can be opposed to the rationalization of what is now an 8,000-page tax code, I think?

But the politics is dreadful, because it means taking away things from constituents. I mean, there's a reason these - the codes are 8,000 pages, because you've got lots of giveaways -

FERGUSON: Right.

ZAKARIA: -- to individual special interests who will lobby very hard to stop that. When you look at this, I mean, you're a historian of empires, there is - you get a feeling that this is a very mature political system that is very good at doling out goodies to all kinds of people. Is it possible to achieve the kind of radical reforms, you know, are we just too - too far gone?

If I look at the kind of things the Ryan plan talks about, you'd be talking about wholesale reform of, you know, in 10 different areas of fiscal policy.

FERGUSON: Right.

ZAKARIA: We can't - we can't raise the retirement age in social security by one year.

FERGUSON: Right. And I - I think that's a really good way of thinking about it. One -- one of the things that historically kills a great power or an empire is when the domestic finances start to go badly wrong, because there are so many constituencies that have to be bought off in order to preserve power at the center that you end up with structural deficits.

This was the experience in the U.K., in Britain. It was the experience in 18th century France. And there comes a point when that strategy of domestic appeasement of interest groups ultimately produces a fiscal crisis that undercuts your ability to project power abroad.

Put it this way. There comes a moment when you're paying more to service your debt than you are to pay your troops in the field. And when you get to that point, and the U.S. is getting pretty close to it when the interest payments exceed the military budget, it's usually a sign that the game is going to be up for your - for your empire, for your overseas power.

I worry a little bit that the United States is in that predicament. And I also think of Churchill, who was a great student of these matters, who said the United States always does the right thing when all the alternatives have been exhausted. I feel like we're doing that economically right now. We're trying all the alternatives, and we'll only do the right thing when another big financial crisis, this time a fiscal crisis driven by the bond market, forces the politicians in Washington to get serious about radical reform.

ZAKARIA: But that means that you do believe that there will be a moment where the international bond markets, that that is the people who lend us money everyday, as you say, we borrow about a trillion dollars a year, they're going to say we're scared by your - the - the prospect of your budget deficits and we need a lot more in terms of interest payments.

FERGUSON: Right.

ZAKARIA: You think that's likely in the near future?

FERGUSON: Yes. Let's be clear about what the near future is. I think not this year because right now the action is all a crisis of confidence in European sovereign borrowers. But over maybe a two- or four-year time horizon at some point the fiscal arithmetic catches up with the United States because, you know, we are facing an exploding debt. And although the interest rate at the moment on a 10-year bond is maybe 3.2 percent, which is historically very low, it doesn't take much of an increase on that, maybe to 4.2 or 4.5 for the costs of debt service to mount.

And Morgan Stanley is forecasting 4.5 percent yields at the end of - for the year. So this is, you know, this is something which could quite quickly spiral. And the point that I'm trying to get across is that this can go wrong very suddenly.

ZAKARIA: Right.

FERGUSON: What the Greeks discovered, what Spain is currently discovering, is that when you lose the confidence of the market, when suddenly your spreads blow out, you're suddenly spending one percent, two percent, three percent more servicing your debt, then the red ink begins to - to spill in all directions because you're actually borrowing just to pay the interest on the money you borrowed before.

ZAKARIA: So when you look at this question of how do you get the private sector to hire more people, how do you get growth through private sector rather than through more government spending, what strikes me is if you look at corporate America, the situation from the point of view of American corporations is extraordinarily healthy.

FERGUSON: Yes.

ZAKARIA: They have enormous amounts of cash on their balance sheet. What that means is that they have - they're earning lots, they have retained that - those earnings, and they have the money ready to invest in plants, capital, workers, but they're not doing it.

FERGUSON: Right.

ZAKARIA: Why are they not investing?

FERGUSON: They're not doing it because they see an outlook which is alarmingly deflationary and they see an outlook which implies higher taxes from a Democratic administration with a left of center president, I don't think that's an irrational expectation right now. And - and that's why I think some kind of really quite radical policy step, preferably announced by Paul Volcker, might just be the signal to non-financial corporate America, you know what, it's going to be I think a good 10 years, not a bad 10 years. We aren't going to be Japan. We're going to bounce out of this the way we did under Ronald Reagan.

And let's think back to the 1970s, which is after all where a large part of my Siegmund Warburg biography is set, we - we've kind of seen this movie before, where the economy is growing slowly, you feel you're losing it strategically, confidence is very low, investors are kind of terrified, they don't know where to go. It took quite radical reforms including tax cuts, but also including - including reform of social security to persuade people by the early 1980s, you know what, it is morning in America, we do have a confident future to look forward to.

Without that kind of radical political step change, I think the economy gets trapped in a low equilibrium with growth in the one or two percent range, permanently high unemployment, a lost generation of young people who just can't get work, and in a sense a European outcome. That's what President Obama has to avoid. And if he can figure out a way of - of changing the mood, creating a real boost I think particularly to private sector business constant, then we have way out.

ZAKARIA: To complicate the story even further, though, the difference between the '70s and now if you're a corporate CEO, is you're looking at China, India, Indonesia, Brazil which are growing very fast and you're looking at your - at your balance sheet and you have all this money and you're saying I could open a plant in America with, you know, whatever, $50,000 of, you know, average worker's wages or I could open it in China at $10,000. FERGUSON: But of course in the 1970s you had Japan and you had West Germany and there were lots of people who said it's over for the United States, these new dynamic post-war economies are going - are going to clean our clock. I don't think it's a foregone conclusion that China overtakes the United States as the biggest economy in the world in 2027, as some people forecast, though it is a foregone conclusion I think now that it will be the biggest manufacturer in the world next year.

The - the key question, and I've just been in China (ph) thinking a lot about this, is whether we can clean up our act fiscally and in terms of business confidence and whether they can stabilize their situation, because of course they had the mother of all stimuluses. It was very successful in getting the Chinese economy out of the trap of a west - a western recession. But right now they're facing all the problems of overheating. They've got wage demand suddenly in double digits. They've got property bubbles in at least some parts of the country. And for them it's a very nervous-making time.

So I think what's fascinating from an economic historian's point of view is that we're kind of at a crossroads. We could get it right. They could get it wrong. Of course, it could go the other way. They could carry on getting it right and we could carry on getting it wrong. It's all to play for in this great global shift that we're living through. It's not a certainty that the United States is down and out.

But right now our biggest obstacle is not economic. It's political. If only in Washington they were prepared to think radically about fiscal reform, entitlement reform, tax reform, I think the United States could do what it did in the 1980s and bounce back after a decade of underperformance.

ZAKARIA: So we have to send you to Washington, Niall Ferguson.

FERGUSON: Oh, God forbids.

ZAKARIA: Thank you very much. And we will be right back.

(COMMERCIAL BREAK)

ZAKARIA: OK. So we've now heard from both Paul Krugman and Niall Ferguson.

So what do I think? Well, I think that the case for government spending in the short term is pretty strong. The private sector is simply not hiring yet. Consumers are also being very cautious. You can't motivate either of them any further with the traditional tools that used to be used, lowering interest rates, because interest rates are already close to zero.

If the government were to slash spending in this atmosphere, it would probably send the economy into a tailspin. Joel Klein, the reformist school's chancellor in New York City, told me that when the stimulus money runs out at the end of this year he will have to fire 5,000 school teachers. Multiply that example by hundreds and you have the effect of budget cuts on today's economy.

But I also believe that fears about debt and deficits are real. There is a danger that the stimulus will not be that effective, that it will be more about politics than economics, that temporary government programs quickly become eternal, that the deficit will grow and grow.

So I have a proposal, a kind of grand bargain. Have a second stimulus that is targeted, temporary and effective, and most important, announce the second stimulus coupled with an announcement from the president of a 10-year plan to tackle the budget deficit. This would include significant reductions in entitlement spending, cuts in wasteful subsidies like agriculture, and a new gas tax and a small national sales tax. These measures would dramatically adjust the budget deficit, and they would assure markets that the United States has gotten serious about living within its means in the medium to long run.

I know that we face no borrowing problems today. That's why I'm in favor of taking advantage of the low interest rates at the moment, but I also believe that the lesson of the last three years is surely when things are out of whack you can sail along just fine for years but then the storm could hit you very suddenly. Housing prices never fell, people said, until suddenly they started crashing. Banks will never run out of money, people said, until they did. The United States has never had trouble borrowing money until one day it might.

It's the small chance of a very bad outcome, something that economists call tail risk, and it's something that everyone from the banks to BP to governments should all be more attentive about.

I actually think that both Professors Krugman and Ferguson would be comfortable with my grand bargain as long as all parts of it were worked out. But some will say that we can't calibrate policy that carefully, that we're not capable of that level of sophistication. This cannot be true. We are living through an incredibly difficult set of economic challenges, the worst in generations. We have to be able to put forward the best solutions, not simply the ones that are politically feasible.

I refuse to accept that the only government in the world that can act sensibly for the long term is a dictatorship in Beijing. President Obama has said that the real need is not for big government or small government but smart government. So here's his chance to demonstrate that proposition.

We will be right back.

(COMMERCIAL BREAK)

ZAKARIA: Now for our "What in the World" segment. Listen to President Obama as he laid out the U.S. mission in Afghanistan last December from West Point.

(BEGIN VIDEO CLIP) BARACK OBAMA, PRESIDENT, UNITED STATES OF AMERICA: Our overarching goal remains the same - to disrupt, dismantle, and defeat al Qaeda in Afghanistan and Pakistan and to prevent its capacity to threaten America and our allies in the future.

(END VIDEO CLIP)

ZAKARIA: Now, listen to CIA Director Leon Panetta last Sunday. ABC's anchor Jake Tapper's question was how many al Qaeda are in Afghanistan?

(BEGIN VIDEO CLIP)

LEON PANETTA, DIRECTOR, CENTRAL INTELLIGENCE AGENCY: I think the - you know, the estimate on the number of al Qaeda is actually relatively small. I think at most we're looking at maybe 50 to 100, maybe less. It's in that vicinity.

(END VIDEO CLIP)

ZAKARIA: So if al Qaeda is down to 100 men there at the most, why are we fighting a major war?

Now, last month alone there were more than 100 NATO troops killed in Afghanistan. That's more than one allied death for each living al Qaeda member in the country in just one month. The latest estimates are that the war in Afghanistan will cost the U.S. more than $100 billion in 2010 alone. That's a billion dollars for every member of al Qaeda thought to be living in Afghanistan in one year.

Look, I understand that al Qaeda is weak and small because we have been fighting them, chasing them, bombing their leaders. We should continue to do that. But why are we fighting this major war against the Taliban? Well, we fight the Taliban because they are allied with al Qaeda, so say people.

But if al Qaeda itself is so weak, why are we fighting against its allies so ferociously? This would be like fighting Italy in World War II after Hitler's regime had collapsed and Berlin was in flames just because Italy had been allied with Germany.

The whole enterprise in Afghanistan feels disproportionate, a very expensive solution to what is turning out to be a small but real problem. Beyond the military money, by the way, there's tens of billions of dollars that flow annually into Afghanistan in aid and logistical support. And how is that money being spent? Well, much of it is literally flying out of Afghanistan.

The "Wall Street Journal" says around $1 billion in cash is flown out of Kabul International Airport every year. As with most countries, private individuals may take money out as long as they declare it. The sums, however, that are leaving Afghanistan are staggering. $2,700,000 in cash is leaving the country every day, and that's only what's been declared. So more money is legally flying out of Afghanistan every year than that nation collects in taxes. The "Journal" reports that the exodus is so large U.S. investigators believe top officials in Afghanistan must be funneling billions of dollars to safe havens abroad. Now, some of this is inevitable. You have a very poor country in chaos and then tons of money pouring in from the outside, from the United States, Japan, Europe.

So my concern really remains the core one I started with. Why? Why are we investing so much time, energy, and effort when al Qaeda is so weak? Is there a more cost-effective way to keep al Qaeda on the ropes than fight a major land and air war in Afghanistan?

I hope someone in Washington is thinking about this and not simply saying we're going to stay the course because, well, we must stay the course.

A ship billed as the world's largest skimming vessel is testing its abilities in the Gulf of Mexico. The ship, called "A Whale" is capable of separating oil from water and can skim about 21 million gallons of oil per day. That's at least 250 times the amount of oil that skimming vessels currently on the job have been able to contain.

Some 60,000 barrels of oil are gushing out of the BP well site, and about 40 percent of that is being captured. Last month, President Obama said up to 90 percent of the oil should be captured within weeks. Calmer seas may finally make that possible.

Hurricane Alex's high seas and winds delayed the use of the helix producer, a ship that can collect about 25,000 barrels of oil a day. It is now expected to be in place by Wednesday.

A top Lebanese cleric, Grand Ayatollah Mohammed Hussein Fadlallah, has died in Beirut. He was the spiritual leader of Hezbollah when it was founded in 1982. a sharp critic of the United States and Israel, Fadlallah used many of his Friday prayer sermons to denounce U.S. policies in the Middle East.

Those are your top stories. Up next, much more "FAREED ZAKARIAH GPS" and then "RELIABLE SOURCES" at the top of the hour.

(COMMERCIAL BREAK)

ZAKARIA: Now, for our question of the week. I think you know what it's going to be.

You've heard how Paul Krugman, Niall Ferguson, and I feel about the key question of our times, what do you think the governments of the world should be doing? What do you think the United States government should be doing? Slashing government spending and reducing the deficit on the one hand, or should it spend its way out of the crisis in the short term?

Let me know what you think.

Don't forget to subscribe to our podcast on iTunes. We've always had a video podcast, now we have an audio one too, and it's doing very well on iTunes thanks to you. Subscribe to it. You will never miss a show, and it is free.

Now, as I do every week, I want to recommend a book. It's summertime, so I thought I'd offer up something a little bit different today. It's a book called "Shop Class as Soul Craft".

The author, Matthew Crawford, says that we have all lost something really great in America when schools started closing up shop classes, when people stopped working with their hands, when manufacturing became assembly lines run by robots.

Now, my personal idea of working with my hands is typing a search into Google to find the best carpenter, handyman, or mechanic, but Crawford lives what he espouses. He quit a prestigious job at a think tank to open a motorcycle repair shop.

This is a fun read. It's a kind of meditation on work and what makes you satisfied. It quotes Aristotle and "Foreign Affairs" magazine. It's a really interesting - a really interesting book, and it might inspire you to do some tinkering of your own. It hasn't done that for me, but I thoroughly enjoyed it.

We will be right back.

(COMMERCIAL BREAK)

ZAKARIA: And now for the "Last Look".

One month and one day ago at Bagram Air Field in Afghanistan, 72 members of the United States military did something unusual. They took a brief pause from the war and they said some words that will change them forever. They promised to support and defend the constitution and laws of the United States of America against all enemies, foreign and domestic, to bear arms on behalf of the United States.

But this wasn't some in-theater enlistment ceremony for new members of the Armed Forces. This was a naturalization ceremony. Those 72 members of the United States military came from 36 different countries, and on that day they all became Americans.

I remember that oath because nine years ago I took the same one as part of a naturalization ceremony. Mine was in an auditorium in Brooklyn, New York.

Every new American has to promise to bear arms on behalf of the United States, but these people were actually doing it and risking their lives before they were even citizens. That's worthy of the honor of being an American, and my hat's off to them. Happy Fourth of July to all Americans, and to the rest of you, think of it as a day to celebrate life, liberty, and the pursuit of happiness.

Thanks to all of you for being part of my program this week. I will see you next week. Stay tuned for "RELIABLE SOURCES".